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Friday, October 12, 2012

When Tradeable Pollution Permits Fall Short

Like a lot of economists, I occasionally break into a semi-spontaneous song-and-dance about how tradeable pollution permits have all sorts of advantages. In an old-fashioned command-and-control system, every firm needs to reduce pollution emissions to a given standard, even though for some firms meeting that standard will be cheap and easy and for other firms it will be costly and difficult. In a system of tradeable pollution permits, firms that can reduce pollution less expensively can do so, and sell their extra pollution permits to other firms. As a result, the goal of limiting emissions can be reached more cheaply. Even better, firms can make money by seeking out innovative ways to cut emissions, because when pollution permits can be sold or need to be bought, there is a clear financial incentive to do so.

Dallas Burtraw has preached this gospel of tradeable pollution permits many times himself, which is part of why I was intrigued by his recent paper "The Institutional Blind Spot in Environmental Economics" (Resources for the Future Discussion Paper 12-41, August 2012). He argues that systems of tradeable pollution permits have one severe flaw: when they set the level of pollution that is allowed to be emitted in future years, they cannot foresee future development that may cause that level to be implausibly high.

For example, the 1990 Clean Air Act set up a framework for using tradable pollution permits that sought to reduce emissions of sulfur dioxide by half from 1980 levels. The program was a success, reducing emissions at cost that were probably 40% or so below the cost of a command-and-control pollution rules. My own Journal of Economic Perspectives ran a couple of articles on the program (here and here) back in the Summer 1998 issue.

Burtraw offers an updated view. As the costs of reducing SO2 emissions and the benefits of doing so became better understood, it seemed clear that SO2 emissions should be reduced much farther and faster. Congress proved unable to make such a chance legislatively, but regulators pushed forward in various ways. The result is that the program for trading SO2 pollution permits worked for a time in the 1990s but since then became irrelevant, with additional declines in S02 trading being driven by old-fashioned regulatory actions. Here's Burtraw (footnotes omitted):

"The trading program was statutorily created in the Clean Air Act Amendments of 1990 and led to cost reductions of roughly 40 percent compared to traditional approaches under the Clean Air Act. However, the program had what literally became a fatal flaw: namely, an inability to adjust to new scientific or economic information. Though information current in 1990 suggested that benefits of the program would be nearly equal to costs, by 1995 there was strong evidence that benefits were an order of magnitude greater than costs. Today the Environmental Protection Agency would argue that benefits are more than thirty times the costs. Unfortunately, to change the stringency of the program requires an act of Congress, at least according to the D.C. Circuit Court. The Act locked in the emissions cap, and despite several legislative initiatives to change the stringency of the trading program, none have been successful. ...

"If the nation’s fate with respect to sulfur dioxide emissions were left to Congress, tens of billions of dollars in additional environmental and public health costs would have been incurred in the last few years and into the future. Fortunately, the inability of Congress to act was backstopped by the regulatory ratchet of the Clean Air Act that triggers a procession of regulatory initiatives based on scientific findings that have been effective in shaping investment and environmental behavior in the electricity sector."

"The sulfur dioxide cap-and-trade program was intended to reduce sulfur dioxide emissions from power plants from anticipated levels of 16 million tons per year to 8.95 million tons per year by 2010. However, evidence based on integrated assessment suggests an efficient level would be just over 1 million tons per year. In the absence of legislative action, regulatory initiatives have taken effect and driven emissions from power plants to 5.157 million tons, as measured in 2010. By 2015, the Clean Air Interstate Rule and the Mercury and Air Toxics Standard will further reduce emissions to 2.3 million tons per year. In doing so, the emissions constraint under the 1990 Clean Air Act amendment has become irrelevant, and the price of those tradable emissions allowances has fallen from several hundred dollars a ton to near zero."

"The sulfur dioxide cap-and-trade program is the flagship example of the use of economic instruments in environmental policy. However, since its adoption in 1990, although the sulfur dioxide trading program gets most of the credit in textbooks, more than half of the emissions reductions that have and will occur are due to regulation."

In short, a scheme for trading pollution permits only works because it sets a firm limit on how much pollution can be emitted--often a limit that is declining over time--and then allows trading of permits within that limit. But if faster reductions in the level of pollution seem useful or cost-effective, perhaps because of changes in the market or in scientific information, the pollution quota often can't be changed. Moreover, the idea that the pollution limit might be adjusted up or down in the future would make it hard for a market of pollution permits to operate.

Burtraw points out that a similar dynamic applies to reducing carbon emissions. Back in 2009, the Waxman-Markey bill that would have set up a cap-and-trade system for carbon emissions passed the House of Representatives but failed in the Senate. At the time, supporters of the bill made some dire predictions about how carbon emissions would increase as a result. But here's the unexpected aftermath. Back at the time of Waxman-Markey, the goal was to reduce carbon emissions by about 10% by 2020, relative to 2005 levels.

However, when Waxman-Markey failed, other events happened. California has imposed rules to limit carbon emissions, along with some other states. The Environmental Protection Agency has looked for ways under existing rules to reduce carbon emissions. The new rules requiring higher fuel economy will reduce carbon emissions. And the advent of more plentiful and cheaper natural gas will reduce carbon emissions. Thus, Burtraw writes: "Total reductions [in carbon dioxide emissions] by 2020—accounting for changes due to subnational policy, regulatory actions under the Clean Air Act, and advantageous secular trends—are on track to yield emissions reductions of 16.7 percent relative to 2005 levels. The anticipated emissions reductions under the Clean Air Act regime exceed those reductions within the United States that would have occurred under cap and trade."

Again, if cap-and-trade legislation had passed back in 2009, it would have set an overall limit on carbon emissions. With that limit in place, any other changes--like cheaper natural gas or higher fuel efficiency standards for cars--would have just made it easier to meet the pollution limit in the cap-and-trade standard. Those unexpected gains in reducing carbon emissions would probably just have led to less need to reduce carbon emissions in any other way.

None of this means that tradeable pollution permits are a bad idea. After all, they were effective in reducing S02 emissions in a cost-effective manner in the 1990s, as well as reducing lead emissions in the 1980s. But when there are ongoing changes in the economic factors affecting the magnitude of emissions, the technology for reducing emissions, and the scientific evidence about the cost of emissions, setting a specific limit on the quantity of pollution allowed may be even harder than it looks.